Indexation: Capitalist Tool (Delivery Agent of the Great Bubble)

Indexation: Capitalist Tool (Delivery agent of The Great Bubble)

October 4, 2016 - Prepared Exclusively For:

Question: What price for the extra risk?

Benchmark Yield YTM Sobriety Test Yield YTM U.S. Treasury 10-Year Note 1.7% Russian Federation, BB+, 14-year bond ?? IBM Bond, AA-, 10-Year Note 2.5% Petrobras, BB , 4-year note ?? Wendy’s Bond, CCC+, 10-Year Note 6.9% Lebanese Republic, B-, 5-year note ?? iShares High Yield Corp. Bond ETF 5.6% iShares Emerging Mkts High Yield Bond ETF 6.3%

Data as of 9/13/2016 Source: Bloomberg

Benchmark Yield YTM Sobriety Test Yield YTM U.S. Treasury 10-Year Note 1.7% Russian Federation, BB+, 14-year bond 2.3% IBM Bond, AA-, 10-Year Note 2.5% Petrobras, BB , 4-year note 6.4% Wendy’s Bond, CCC+, 10-Year Note 6.9% Lebanese Republic, B-, 5-year note 6.2% iShares High Yield Corp. Bond ETF 5.6% iShares Emerging Mkts High Yield Bond ETF 6.3%

Source: Bloomberg. Data as of 9/13/2016

Would anyone seriously argue that these yields are adequate compensation for the risk assumed? (That is, could you sell a Lebanese Republic bond in the open market at 6.2%?) If not, do the prices result from some other factor, such as artificial supply-and-demand pressures?

In EMHY, new money is allocated based on float. In other words, the more debt a nation issues, the greater the allocation to its bonds because it has a greater capitalization. That is the mathematical model, and that is entirely logical – to a point.

There is, really, no price discovery. And if there’s no price discovery, is there really a market? In which case, what is EMHY really worth?

10-Yr Treasury Rate

We are now in the opposite circumstance: 16 the current generation of financial professionals has lived 35 years of, 14 essentially, only falling interest rates. If their In the 35 years leading up to first Wall Street job was at 22, they are 1981, an entire generation of approaching 60. They, too, have known no 12 financial professionals was other reality, but the consequences of trained that knew no reality being unprepared are much more grave. 10 other than rising interest rates and inflation. They were unprepared for the reversal 8 that eventually occurred.

10 Year10 Rate (%) 6

Source: Federal Reserve Bank of St. Louis

For the first time since the late 1940s, stocks and bond S&P Dividend Yield vs. 10-Yr Rate yields have converged. Once upon a time – say for 16% the prior 80 years – investors demanded higher yields from stocks since the risk was greater. Could both 14% asset classes be overvalued? If nothing else, caution is in order, and investors should be very thoughtful, perhaps more than at any other time in their careers, 12% about where capital is being put at risk and why. 10% In this historically low return environment, meaning in

the last 5,000 years, we are most certainly in untested 8% territory. The cash-as-a-liability mentality is very likely creating balance sheet bubbles. Many investors wish 6% for the cash on the balance sheet to be “spent” – through share repurchases, dividends, or acquisitions. But this is only a productive use of cash if the 4% transactions are done at attractive valuations, and without taking on more leverage than appropriate. 2%

Those who still believe that cash is a valuable asset 0% and a protector against financial difficulty and a well of investment possibilities when the tide turns could 1871 1878 1885 1892 1899 1906 1913 1920 1927 1934 1941 1948 1955 1962 1969 1976 1983 1990 1997 2004 2011 be rewarded in the years to come. S&P 500 Dividend Yield 10-Yr Treasury Rate

Source: Market Volatility, R. Shiller, MIT Press, 1989, and Irrational Exuberance, Princeton 2015.

And its unintended distortions Annual Fund Flows and Volatility Phobia ($mill) Index domestic Actively Index domestic equity mutual Managed Equity The Exodus: $1.1 trillion+ into equity ETFs indexed equities, $0.8 trillion+ out of Year funds Mutual Funds 2007 38 88 -62 active management. 2008 41 129 -149 2009 35 31 -27 In 2005 there were 204 ETFs in the 2010 24 47 -70 U.S.; in 2015, 1,594 – even as the 2011 30 46 -125 number of listed stocks declined. 2012 31 81 -140 2013 69 103 -2 2014 83 141 -84 2015 74 64 -176 Cumulative $425 $730 ($835)

1,000

800

600

400

200

-200

-400

Cumulatiive Net Flows ($B) Flows Net Cumulatiive -600

-800

Index domestic equity mutual funds Index domestic equity ETFs Actively managed domestic equity mutual funds Source: Investment Company Institute

Turnover rates for two of the most popular ETFs Annual Share Turnover are higher than 3500%(!), an average holding period of about a week. That is dozens of ExxonMobil 90% times greater than the trading liquidity of IBM Corp 128% even its most liquid constituents. Vanguard 500 Index Mutual Fund (VFINX) 42% It has been estimated that ETF providers SPDR S&P 500 ETF (ticker SPY) 3,507% collect about $6 billion per year from iShares Russell 2000 Index (IWM) 3,624% management fees. But roughly $9 billion is *Source: Morningstar, iShares, Bloomberg, based on last annual report for collected from market-making spread. each fund. For calendar 2015

Largest Intra-Day Drop in DVY Constituent Prices: 8/24/15 3%

-2% When the music stops, is there enough underlying liquidity? -7% Public Service Philip Morris Intl Intel Aug 24, 2015 Dress Rehearsal: -12% Enterprise Group Coca-Cola Emerson Electric Prices of the iShares Select -17% Eli Lilly McDonald's Dividend ETF (DVY) , -22% temporarily dropped 35% while the NAV declined by a mere -27% General Electric 2.5%. -32% DVY -37%

*Source: Morningstar, iShares, Bloomberg 7 © 2016 Horizon Kinetics LLC.™ Indexation’s Top-Heaviness Problem Self-defeating paradox: the formulaic pursuit of diversification creates a new form of idiosyncratic risk

Do investors in the iShares U.S. Energy ETF, IShares US. Energy ETF (IYE) who presume to be buying a diversified portfolio – who were fleeing idiosyncratic Exxon Mobil Corp 25.0% risk – know that 50% of the fund is held in 4 Chevron Corp 13.1% holdings, that they are actually buying Schlumberger Ltd 7.6% idiosyncratic risk? Occidental Petroleum Corp 4.1% Total Weight of Largest 4 Holdings 49.8%

The same top-heaviness problem exists in IShares MSCI Spain Index ETF (EWP) the iShares MSCI Spain Index ETF (EWP). Banco Santander SA 13.1% The top 10 companies are a 64% weight. Telefonica SA 9.0% Banco Bilbao Vizcaya Argentaria 7.6% Iberdrola SA 7.1% Industria De Diseno Textil Inditex 6.8% Amadeus IT Holding SA 4.9% Repsol SA 4.8% Red Electrica Corporacion SA 3.8% Aena SA 3.6% Ferrovial SA 3.5% Weight of Largest 10 Holdings 64.3%

*As of 6/30/2016. Source: Morningstar, iShares, Bloomberg 8 © 2016 Horizon Kinetics LLC.™ The Semantic Mis-Investing Problem in Indexation How to NOT Invest in the Dynamism of Foreign Markets: Through Your Foreign Markets ETF

Does an asset allocation program or robo- IShares MSCI Spain Index ETF (EWP) advisor tool seeking foreign market exposure % of Revenue NOT in Spain know that 6 of the top 10 holdings of the Banco Santander SA 88.0% iShares MSCI Spain Index get 70% or more of Telefonica SA 73.7% their revenues from outside of Spain? That a Banco Bilbao Vizcaya Argentaria 71.6% purchase of the ETF is, essentially, investing Iberdrola SA 55.0% outside Spain? The same holds true for Industria De Diseno Textil Inditex 82.3% emerging markets ETFs. Amadeus IT Holding SA 96.2% Repsol SA 47.6% There is also valuation as a consideration. Red Electrica Corporacion SA 2.1% These relatively few companies of sufficient Aena SA 5.9% stock market value and trading volume are in Ferrovial SA 72.2% great demand, simply as raw material for Source: Companies’ 2015 annual reports, Bloomberg inclusion in the index funds. Might these mega- cap global stocks have outperformed truly local, stocks in Spain due to their automatic bid? Might global multi-nationals pose their own particular systemic risk?

So what does manager relative performance measure? What does country allocation measure?

9 © 2016 Horizon Kinetics LLC.™ A Security Exercise in Levitation The Exxon Conundrum – Or, The Problem of the Automatic Bid As early as 2005, Standard & Poor’s moved to a market cap float-adjusted weighting methodology (so that Wal- Mart and Microsoft’s weightings, among others’, would be reduced by their roughly 40% insider ownership). It improved SPY’s scalability for additional AUM. Did they adjust the historical S&P 500 returns to be comparable to the post-2005 index returns? If not, did the asset allocation modelers adjust their historical return ‘facts’? Ever since, the business demand of ETF organizers for liquid stocks has only increased, with the influx of funds directed into the same limited population of liquid stocks. ExxonMobil is one of the most liquid. Ergo, it will be found almost anywhere one can imagine that it can be placed. It’s Growth, It’s Value, Its’ a Bird, It’s a Plane…

It’s Exxon, a Stock for Every Strategy: ExxonMobil: An Exercise in Levitation QUAL iShares USA Quality Factor ETF $ in bill., except per share data DGRO iShares Core Dividend Growth ETF Q2 2013 Q2 2016 Change HDV iShares Core High Dividend ETF Revenue $106.47 $57.69 -46% IWD iShares Russell 1000 Value ETF EPS $1.55 $0.41 -74% EXT WisdomTree Total Earnings ETF Payout Ratio 41% 183% 350% PBP PowerShares S&P 500 BuyWrite ETF TILT FlexShares Morningstar US Market Factors Tilt ETF BV/Share $37.63 $41.14 9.3% QUS SPDR MSCI USA Quality Mix ETF GSLC Goldman Sachs ActiveBeta US Large Cap Equity ETF (Net Expenditures on Stock $5.52 14.7% JHML John Hancock Multifactor Large Cap ETF buybacks/share) TOK iShares MSCI Kokusai ETF Total Debt $19.40 $44.50 129% ACWI iShares MSCI ACWI ETF MMTM SPDR S&P 1500 Momentum Tilt ETF DVP Deep Value ETF Share price $90.35 $93.74 4% USWD WisdomTree Weak Dollar US Equity ETF *As of 6/30/2016. Source: Morningstar, iShares, Bloomberg

The popular side of the ETF Divide, Correlation with S&P 500* witnessed in the ExxonMobil phenomenon, Security 1995 2015 Change can be seen in almost any large S&P 500 Apple Inc 0.160 0.662 313.75% constituent. Money has been structurally Chevron 0.291 0.686 135.74% channeled into the most liquid securities. General Electric 0.522 0.692 32.57% Johnson & Johnson 0.311 0.790 154.02% It alters correlation statistics, risk statistics. Microsoft 0.465 0.684 47.10% The correlation of the largest members of Pfizer 0.191 0.717 275.39% the S&P 500 with the index has about Procter & Gamble 0.368 0.735 99.73% doubled from 20 years ago. AT&T 0.428 0.711 66.12% Verizon 0.439 0.721 64.24% Even Mexico and Japan are now more ExxonMobil 0.350 0.732 109.14% correlated with the S&P 500 than the top S&P 500 companies were 20 years ago! Correlation with S&P 500* (12/31/07-06/30/16)

The same holds true for Procter & Gamble, IYW iShares US Technology 0.903 Coca Cola and most of the rest. Where’s BJK Market Vectors Gaming 0.807 the price discovery? IYH iShares US Health Care 0.815 IYE iShares US Energy 0.755 ITB iShares US Home Construction 0.681 IYT iShares Transportation Avg 0.858 EWW iShares Mexico Capped ETF 0.826 EWJ iShares MSCI Japan ETF 0.739 Source: Bloomberg, monthly returns, Horizon Kinetics Research *Selected non-fin’l S&P 500 constituents that have existed for 20 years Using Bloomberg correlation matrix (12 months daily return)

11 © 2016 Horizon Kinetics LLC.™ The ETF Divide: More of The Popular Sorts Endless examples of the automatic bid in basket-based investing 12-Mo Change in Revenue Which Coca-Cola is More Expensive? 30 Largest S&P 500 Companies 1970s Present Apple Inc. -2.05% Pfizer 9.72% EPS EPS Rev. Microsoft -8.83 Chevron -32.71 P/E Growth P/E Growth Growth Exxon Mobil -30.70 Merck -2.00 1969 36.0x -- 2013 21.23x -3.00% -2.42% 1970 30.5x 16.98% 2014 20.63x -1.92% -1.96% Johnson & Johnson 1.15 Intel 2.47 1971 36.7x 13.71% 2015 20.98x -1.96% -3.81% Amazon.com 25.91 Coca-Cola -5.38 1972 41.1x 13.48% 2016E 22.20x -4.50% -6.04% Facebook 51.38 Bank of America -4.55 1973 36.9x 12.50% General Electric 2.19 Home Depot 7.70 1974 26.3x -8.89% Berkshire Hathaway 4.83 Comcast 6.83 1975 18.3x 21.95% AT&T 16.64 Cisco Systems 0.17 1976 17.7X 19.00% JPMorgan Chase -3.22 Visa Inc. 6.31 1977 14.3X 12.18% Procter & Gamble -7.70 Philip Morris Int'l. -8.68 1978 13.6X 13.48% Alphabet Inc. Cl. A 17.45 PepsiCo -4.80 McDonald’s, Another Case of Automatic Daily Bid Alphabet Inc. Cl. C 17.45 Citigroup Inc. -6.49 Wells Fargo 3.02 Walt Disney 9.08 ($ in billions) 2008 2015 Change Revenue $23.52 $25.41 8.0% Verizon 0.88 I.B.M. -7.65 Net Income $4.31 $4.53 5.0% Average change: 1.93% Long Term Debt $10.19 $24.12 136.8% Excluding Amazon, Facebook, Google: -2.20% Equity $13.38 $7.09 -47.0% Weighted Avg. Shares 1.146 0.939 -18.1% Source: Company Research, Bloomberg, through 6/16 *Selected S&P 500 constituents that have existed for 20 years Share price, end of yr. $ 62.19 $ 118.14 90.0% P/E ratio, yr-end px 16.9x 24.6x 45.3% Source: Historical data from Moody’s Handbook of Common Stocks; 2014-2016 data from Bloomberg

As the saying goes, once everyone’s in, Year 2015 Total there’s only one place to go. Top 10 Contributors to S&P Return Return Amazon.com Inc 117.8% One would do well to remember that Microsoft Corp 22.7 this state of affairs is not a new Alphabet Inc Class A 46.6 phenomenon. In prior eras, it was known Alphabet Inc Class C 44.6 as go-go investing, or trend following. General Electric Co 27.5 Facebook Inc Class A 34.1 Now it takes the guise of index-based Home Depot Inc 28.5 asset allocation. All such phenomena Starbucks Corp 48.2 have ended unpleasantly. Netflix Inc 134.4 The index universe has become, simply, McDonald's Corp 30.4 a big momentum trade (or, perhaps, an Weighted average return: 44% interest rate momentum trade). It is the Contribution to S&P return: 245% most crowded trade in the history of S&P 500 Index return: 1.4% investing. S&P return without Top 10: -2.7% Revenue growth (simple avg.) 9.9% And crowded trades eventually attract short sellers. Source: Factset, using iShares Core S&P 500 ETF as a proxy for the S&P 500 Index

A rhetorical question: Would an active manager of a low-risk strategy be permitted Sample 10 Low Volatility ETFs the risk of a near-50% weighting in What is financials? Beta This Column? A reality: A new ETF cannot be launched USMV iShares MSCI USA Minimum Volatility ETF 0.72 9.8% without a low Beta. SPLV PowerShares S&P Low Volatility ETF 0.72 18.7% A result: These largest-in-class ETFs can EFAV iShares MSCI EAFE Minimum Volatility ETF 0.75 11.8% legitimately be characterized as low EEMV iShares MSCI Emerging Markets Min Vol ETF 0.90 24.3% volatility, since of late the financial sector ACWV iShares MSCI All Country World Min Vol ETF 0.68 16.7% has not been volatile. And the high weighting enables the ETF to attain its ONEV SPDR Russell 1000 Low Volatility ETF 0.78 22.4% advertised low Beta. XMLV PowerShares S&P MidCap Low Volatility ETF 0.76 48.6% XSLV PowerShares S&P SmallCap Low Volatility ETF 0.80 49.2% Another rhetorical question: Is low volatility IDLV PowerShares S&P Intl. Developed Low Vol ETF an inherent attribute of companies in the 0.75 35.8% financial sector? Or is it perhaps simply that EELV PowerShares S&P Emerging Mkts Low Vol ETF 0.86 30.9% the central banks of the world have maintained an artificially low-rate environment for a very long time?

Would anyone legitimately assert that these ETFs will remain non-volatile if rates rise? The ETFs can’t trade out of a low-Beta security; but they can once the Beta rises. Source: Various ETF Factsheets, Bloomberg. Beta from inception of each ETF through August 31, 2016

Were these active managers the 2015 2014 anomaly for underperforming? Fund or Holding Underperformance Underperformance And is it reasonable to believe Company in % Points (net) in % Points (net) that they all lost their touch at the Fairholme -12.90% -16.40% same time? Gabelli Value -10.89% -12.10% Wintergreen -8.32% -15.40% Or was it the S&P 500 that was the Longleaf Partners -20.18% -8.80% anomaly for outperforming? That 1 always sounds nonsensical until Berkshire Hathaway -13.90% 14.00% 2 after the fact. Pershing Square Hldgs -21.90% 27.40% Icahn Enterprises2 -16.80% -27.35% All one can say is that if a school Greenlight Reinsurance2 -21.60% -4.30% consistently gave exams that 98% Royce Micro-Cap -13.10% -9.50% of the students would fail, at least some attention would be paid to the teachers. 1Share price return; book value per share return +8.3% for 2014, +6.4% for 2015 2 NAV per share change Source: Company Reports, Horizon Kinetics Research

15 © 2016 Horizon Kinetics LLC.™ Central Banks, Equities and, Of Course, Indexation Still believe in price discovery? Q: Which Index Fund Would Be the 4th Largest ETF in the U.S.? How can a free enterprise system function as such if price discovery is to be Q2 2015 Q2 2016 influenced by agencies of government Market value of holdings $38.6 B $61.8 B with infinite supplies of money? Number of positions 2,581 2,581 Top 10% by weight, # of positions 258 258 An equity portfolio manager is no longer competing in the market auction process Largest 10% as share of portfolio 74% 76% with other buyers with limited capital, Average market cap of largest 10% $60.4 $62.7 however vast that sum of capital might (billions) be. The government is not motivated by ordinary considerations of fair value. One is entitled to presume, in the absence of Some Unexpected Holdings evidence to the contrary, that the aim of Name Headqtrs Name Headqtrs the Central Bank is to elevate prices. If B Communications Ltd Ramat Gan Kornit Digital Ltd Rosh Ha'ayin this is the case, what can be the Caesarstone Ltd Haifa Mellanox Tech Ltd Yokneam meaning of the benchmark? Cellcom Israel Ltd Netanya Neuroderm Ltd Rehovot Without price discovery unimpeded by Check Point Software Tech Tel Aviv-Yafo Orbotech Ltd Yavne intervention, there can be no rational Cyberark Software Ltd Petah Tikva Radware Ltd Tel Aviv-Yafo allocation of capital. Furthermore, Elbit Sys Ltd Haifa Taro Pharma Inds Haifa without rational allocation of capital, it is Gazit Globe Ltd Tel Aviv-Yafo Tower Semicond. Migdal Ha'emek impossible to properly evaluate the skill of Israel Chemicals Ltd Tel Aviv-Yafo Wix Com Ltd Tel Aviv-Yafo the managers. Ituran Location & Control Azour Source: sec.gov 13F Filings

* From the Swiss National Bank: “The SNB does not engage in equity selection; it only invests passively. It first decides in which markets it wants to invest, and then replicates appropriate broad equity indices. If the equity portfolio were managed actively, this could send undesirable signals to the 16 market, and might also lead to the politicization of investment decisions.” © 2016 Horizon Kinetics LLC.™ I Robot: The Age of Machine Investing

Does the Swiss National Bank have a special affinity for Israel? Or a subtle asset allocation sub- strategy? Why does it hold 17 Israeli stocks in its U.S. equity portfolio? Like any analysis, information is revealed by thoughtful examination of facts and relationships. The Bank’s 2,581 different stocks are not chosen by actual analysts. They’re chosen by machine. The machine must be programmed. Do the programmers in Zurich know that a CUSIP that begins with a letter, as opposed to a number, signifies a foreign company? Why would they? So, the Swiss National Bank affects the clearing prices of Israeli as well as U.S. stocks. And they don’t even seem to know it. What else don’t the machines know?

Largest 5 Holdings (Cusip) Largest 5 Israeli Holdings (Cusip) Apple Inc (037833100) Check Point Software Tech LT (M22465104) Exxon Mobil Corp (30231G102) Taro Pharmaceutical Inds Ltd (M8737E108) Microsoft Corp (594918104) Israel Chemicals Ltd (M5920A109) Johnson & Johnson (478160104) Elbit Sys Ltd (M3760D101) AT&T Inc (00206R102) Mellanox Technologies Ltd (M51363113)

Source: sec.gov 13F Filings, Factset

* From the Swiss National Bank: “The SNB does not engage in equity selection; it only invests passively. It first decides in which markets it wants to invest, and then replicates appropriate broad equity indices. If the equity portfolio were managed actively, this could send undesirable signals to the 17 market, and might also lead to the politicization of investment decisions.” © 2016 Horizon Kinetics LLC.™ The New Division Between Liquid (Index Filler) and Less Liquid

Real Estate / Land Simon Property Howard Hughes Dream Unlimited Group Corp. Market Cap ($ bill.) $65.46 $4.54 $0.44 Inside Ownership* 7.09% 13.80% 35.65% 30 Day Avg Vol. (000) 1,279 142 6 Price/Book Value 14.3x 1.8x 1.0x For Howard Hughes, management warrants would add 6.7% to insider holdings Source: Company reports, Bloomberg. Data as of 9/12/16.

Shipping AP Moller- Subsea 7 Stolt-Nielsen Siem Industries Maersk Market Cap ($ bill.) $29.17 $3.25 $0.85 $1.06 Inside Ownership 70.3%* 21.3% 58.2%* 79.2% 3-mo Avg Vol. (000) 93.056 27.432 1.257 0.895 Price/Book Value 0.87x 0.59x 0.53x 0.37x *Voting rights Source: Company reports, Bloomberg. Data as of 9/27/16 or most recent company report.

Past performance is not indicative of future results. The information contained herein is subject to explanation during a presentation.

Note that indices are unmanaged and the figures shown herein do not reflect any investment management fee or transaction costs. Investors cannot directly invest in an index. References to market or composite indices or other measures of relative market performance (a “Benchmark”) over a specific period are provided for your information only. Reference to a Benchmark may not reflect the manner in which a portfolio is constructed in relation to expected or achieved returns, portfolio guidelines, correlation, concentrations, volatility or tracking error targets, all of which are subject to change over time.

The S&P 500 Index (“SPX”) is a broad based index widely considered as a proxy for overall market performance. It is the property of Standard & Poor’s ®.

All ETFs mentioned have fees and expenses. You should read their prospectus before investing. All material presented is compiled from sources believed to be reliable, but no guarantee is given as to its accuracy.

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